Trading Investment Trusts

Tuesday, 28th August 2012 09:03 - by David Harbage

Prompted by the recent news surrounding the financially-challenged Mouchel Group (going into administration), a number of private investors were debating the question of how an investment could be made into smaller (say non-FTSE100 index) sized companies, without incurring the potential risk of losing almost all of one’s money.

Almost everyone present agreed that stock exchange listed smaller or mid cap companies were both more interesting and potentially more rewarding than larger multinationals– as larger financial institutions may not research, or be able to take meaningful stakes, in businesses with an enterprise value of say less than £1 billion.

Smaller companies are inherently higher risk, but there is an alternative

In the absence of sufficient monies, or stock-specific knowledge, to create a balanced portfolio – of say at least 20 smaller companies – the writer opined that a collective investment was the logical means of gaining exposure, and mentioned several open ended funds (including the Old Mutual Mid Cap and Standard Life Smaller Companies unit trusts) which can boast an impressive track record of good historic performance relative to their peers. Beyond unit trusts or open ended investment companies, investors with perhaps a greater level of interest in stock exchange instruments are likely to be aware of a near forgotten alternative: close-ended investment trusts.

Investment trusts: a more interesting collective?

Because they are stock exchange listed companies in their own right, which will fall or rise in response to investor perception of their respective merits – as well as by reference to the worth of the underlying portfolio of investments (described as the Net Asset Value, or NAV) – the valuation mechanics are less straightforward than an open-ended company or unit trust, whose shares or units are valued by specific reference to the pool of assets. Understandably, some investors will shy away from what they perceive as an additional risk but others will embrace the discount or premium – between an investment trust’s share price and its NAV – as an opportunity to ‘add value’ or incremental return.  

UK Smaller Company trusts currently bear a neglected appearance

Based on share price to net asset value, investment trusts investing in domestic medium sized and smaller companies (non-FTSE100 index constituents) currently appear undervalued. This assertion is made on the basis of studying the historic discount or premium relationship. Of the 15 investment trusts in the UK Small Cap or UK Mid Cap categories, the share prices of 12 are currently exhibiting higher discounts (or smaller premiums) to NAV than their 12 month average – and only 1 is clearly ‘bucking this trend’. However, as the well worn warning, but wholly helpful truism, states “past performance may not be a useful guide to future returns”; for example, the fund manager(s) responsible for previous performance may have departed for pastures new. 

Perhaps with good reason

In an economic slowdown, especially one where the domestic pace lags the global trend, UK smaller companies – which, in aggregate, tend to possess higher inherent growth and a greater bias towards the local economy – historically underperform larger multinational businesses. However, historical precedent also suggests that smaller or medium sized companies tend to outperform larger ones over the longer term (as evidenced by the FTSE250 index delivering a total return of 1030%, since its inception in January 1986, versus the FTSE100’s comparable income inclusive return of 450% to date). Incidentally, the wider FTSE All Share index, which incorporates a high number of smaller businesses (typically those with an equity market capitalisation of less than £300 million) – albeit companies with a full stock exchange listing - has also outperformed the FTSE100 index over the past 25 years.

Therein lies opportunity

If discounts of UK Small and Mid Cap investment trusts are stretched at the bottom of an economic cycle, then investors capable of calling a positive change - in both the underlying economy and investor sentiment - may procure additional benefit, as the share price to NAV discount tightens or premiums extend. With the outlook for the UK economy remaining unpromising (although GB plc may be in ruder financial health – primarily by reference to balance sheet – than is generally supposed), it may be too early to make the call to favour small cap over large. However, carrying out due diligence ahead of an intended purchase is imperative in recognition that markets can and do move very quickly upon any whiff of change in the prognosis.

Consider anomalies in current valuations

Standard Life Smaller Companies investment trust stands out as being especially favoured – by reference to its current stock price of 217 pence equating to the NAV, while the average discount of the remaining UK Small Cap universe is 18.5%. The answer almost certainly resides within the trust’s superior performance as, over the past 15 years, its manager Harry Nimmo has delivered excellent returns in this asset class. However, while the discount to NAV has tightened from 9.5% to move towards premium status, underlying portfolio (NAV) performance over the past year has matched, rather than exceeded the peer group, and as such better opportunities may reside within one of the trusts which have not enjoyed the benefit of an incremental (non-NAV driven) 9% price appreciation.

Beyond the share price to NAV factor, there’s another geared element

As companies, investment trusts can borrow monies to boost the purchase of assets – typically reflecting their managers’ expectation of returns (in excess of the cost of servicing the debt) from the asset class and their underlying portfolio. Clearly, this financial gearing provides another layer of risk and return (on top of NAV performance, and share price to NAV relationship); amongst the 15 UK Small Cap and UK Mid Cap investment trusts, gearing averages 109% of asset worth and ranges between those with none (4 have ostensibly no debt), most around the 110% mean and two more highly geared outliers. The latter features Throgmorton Trust, with 128%, but also the Standard Life vehicle at 118% (although 9% is currently being held in cash assets). Adopting a highly geared position will extend the returns produced by the underling investments; if markets and portfolio constituents rise, then returns will increase proportionately more – but if asset values are falling then performance is adversely exacerbated.  Incidentally, the extent to which gearing will help or hinder returns will, in part, vary according to how expensive the debt is to service (for example some trusts are ‘locked in’ to high coupon long dated debenture or other bond debt). The latter is reflected, by investment trust analysts, when assessing current discounts – as debt is ‘marked to market’ or priced to reflect its impact. 

Style is another differentiator

Besides considering the apparent value on offer – as reflected in the magnitude of any discount to NAV – and being mindful of the financial gearing, investors can choose between fund managers with different investment strategies, notably divided between those who favour growth businesses and those who prefer under or lowly valued stocks. While this applies across most classes of asset, and certainly within equity investment, it is also a consideration when considering past performance and choosing a style which accords with the investors own views or risk profile. The successful Standard Life Smaller Companies trust has a bias towards higher growth companies and its portfolio might favour emerging businesses in industries such as electronics or technology, whereas a value-based approached followed by another Edinburgh-based manger Aberforth Smaller Companies investment trust might prefer to own companies which are more established, paying dividends and possess strong balance sheets. The Aberforth trust currently offers a net dividend yield of 3.5%, whereas the Standard Life trust pays 1.3%, and further information can readily be accessed on current portfolio positioning (by sector, stock exposure, concentration of holdings etc), management strategy or style, size of the investment trust’s market capitalisation (which provides an indication of ease of trading, and tightness in bid-offer spread) and costs (notably annual management fees, which can vary quite considerably, plus performance-related fees) – all via the companies’ own websites.

As is constituent size bias

Investigation of each prospective investment trust company’s website should also incorporate perusal of the benchmark – the objective, against which the fund manager is measured – together with any other pertinent guidelines that may govern how the investment portfolio is managed. For UK Small Cap trusts the most common benchmark index is the Numis Smaller Companies index (previously known as the Hoare Govett Smaller Companies index), excluding investment companies, which extends to all fully listed London Stock Exchange constituents, up to a market capitalisation of approximately £1.25 billion – which pertains to both the previously mentioned Aberforth and Standard Life trusts. Some trusts will manage to strict criteria, for example the JP Morgan Mid Cap investment trust uses the FTSE250 index as its benchmark and the manager will exit stocks that leave their selection universe (either upon promotion to the FTSE100 or on demotion out of the FTSE250). By contrast, other fund managers will have discretion to invest ‘off piste’, with probably the most pertinent segment being the use or exclusion of Alternative Investment Market (AIM) listed companies – for example Throgmorton Trust will own AIM stocks, while Aberforth will not - and unlisted company stocks.

Worth a look

Aggressive, short-term trading-focused investors might decide that Standard Life Smaller Companies investment trust’s negligible discount to NAV represents an example of an overvalued trust, and may be interested in researching the following trusts which all feature longstanding well-regarded managers:

Schroder UK Mid Cap – seeks to outperform the FTSE250 index, but can own up to 20% of NAV in non-FTSE250 stocks. Managed by Rosemary Banyard and Andy Brough, with an emphasis on growth businesses, the trust’s share price and NAV has outperformed its benchmark and mid cap peer group since launch and over the past 5 years. Returns in 2012 have been less impressive, but the discount to NAV (stretching from 6% to 18%) appears overdone. Henderson Smaller Companies – managed by Neil Hermon, with a bias towards growth businesses, the trust seeks to outperform the Numis Smaller Companies index. This it has managed to do over the past 6, 12 and 36 months - but this has not been reflected in the share price’s discount to NAV widening from 16% to 23%. Aberforth Smaller Companies – wholly owned and managed by its six partners, the trust also seeks to outperform the above mentioned Numis benchmark - but by favouring lowly or undervalued stocks. Despite outperforming over the past year, the shares’ discount to NAV has extended from 6% to 16%.

Other potential trading opportunities in trusts

Finally, if this article has whetted investors’ appetite to take a closer look at anomalous valuations within the investment trust world, here are three more examples worthy of further investigation: The first relates to stable mates within the Commodity Specialist sector: Blackrock Commodities Income trust – on a 1% premium to NAV – versus Blackrock World Mining on a 14% discount to NAV.  Within the Global Growth category, Law Debenture (which features another business within its investment trust) is valued on an 11.5% premium to NAV while Edinburgh Worldwide and Monks have seen their share prices slip by up to 10% – relative to NAV over the past year, to reach discounts of 15% and 13% respectively. Finally, investors have meted out considerably different treatment to trusts within the UK Income Growth segment: premium ratings relative to NAV have been applied to Dunedin Income Growth and Edinburgh, whereas double-digit discounts apply at JP Morgan Claverhouse and Merchants. The reader can investigate and determine if such treatment is justified and relative valuations can be sustained.  

The Writer's views are their own, not a representation of London South East's. No advice is inferred or given. If you require financial advice, please seek an Independent Financial Adviser.